House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 3 - Interest withholding tax

Outline of chapter

3.1 Schedule 3 to this bill amends the taxation law relating to interest withholding tax (IWT). It contains three distinct amendments that relate to the imposition of IWT.

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The first set of amendments broadens the range of financial instruments eligible for IWT exemption by including debt interests.

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The second amendment treats payments of a non-capital nature made on certain Upper Tier 2 hybrid capital instruments as interest for IWT purposes.

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The final amendment allows assets and debts to be transferred from Australian subsidiaries of foreign banks to their Australian branches without losing IWT exemptions.

Context of amendments

3.2 The amendments explained in this chapter seek to ensure that the IWT provisions operate as intended in view of other recent developments in the tax law.

3.3 The first set of amendments arises as a consequence of the introduction of the debt/equity rules in 2001. While the concept of interest in the IWT provisions was partially aligned with the new debt/equity rules in 2001, the concepts of 'debenture' and 'offshore borrowing' need to be similarly updated to make the IWT provisions work as intended. This current measure will ensure that payments on financial instruments now treated as debt for tax purposes - including certain redeemable preference shares - will also be exempt from IWT (provided certain conditions are met) if those payments qualify as interest.

3.4 The second amendment complements the Government's decision announced in the Minister for Revenue and Assistant Treasurer's Press Release No. C012/03 of 4 March 2003, to introduce regulations to treat certain Upper Tier 2 capital instruments issued by authorised deposit-taking institutions that are banks as debt for taxation purposes. This amendment ensures that non-capital payments on such instruments are interest for IWT purposes. This change, together with the first set of amendments, will ensure that these payments are exempt from withholding tax in the appropriate circumstances.

3.5 In 2001, changes were made to the IWT legislation to allow non-resident companies (including foreign banks) carrying on business through permanent establishments in Australia to issue debentures that qualify for exemption from IWT. However, the legislation allowing debentures issued after 18 June 1993 to be transferred from Australian subsidiaries of foreign banks to their branches without the loss of IWT exemption was not amended. Therefore, the banks' subsidiaries could not transfer debentures issued after that date to their branches and then wind up their subsidiaries without the loss of the exemption. The final amendment ensures that the IWT exemption is not lost if IWT-exempt instruments are transferred from an Australian subsidiary of a foreign bank to a branch. This will facilitate the transfer of all business from foreign banks' Australian subsidiaries to their Australian branches, if they wish.

Summary of new law

3.6 This bill amends the IWT provisions in Division 11A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) to:

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update the references to 'debenture' and 'offshore borrowing' for IWT purposes by adding 'debt interest'; and

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treat payments made in respect of certain financial instruments - Upper Tier 2 capital - as 'interest' for IWT purposes.

3.7 This bill also amends the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 so that debentures issued after 18 June 1993 that are transferred from Australian subsidiaries of foreign banks to their Australian branches will retain eligibility for the IWT exemption.

Comparison of key features of new law and current law

Detailed explanation of new law

What is interest withholding tax?

3.8 The taxation of Australian sourced interest paid or credited to non-residents, and residents operating through offshore permanent establishments, is dealt with in the IWT provisions contained in Division 11A of Part III of the ITAA 1936. These provisions provide, in conjunction with the Income Tax (Dividends, Interest and Royalties) Withholding Tax Act 1974, that the recipient of Australian sourced interest is subject to withholding tax on the gross amount paid or credited. A rate of 10% of the gross amount of the interest is imposed. The obligation for collecting the IWT is placed on the person making the payment. The provisions define 'interest' and stipulate when an amount of interest is subject to withholding tax.

Interest withholding tax exemptions

3.9 Under certain circumstances, Division 11A of Part III of the ITAA 1936 provides exemptions from IWT. In the context of these proposed amendments the following exemptions are relevant:

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section 128F of the ITAA 1936 ^[F1] provides an exemption from IWT where an Australian resident company, or a non-resident company carrying on business at or through a permanent establishment in Australia, issues debentures and the issue satisfies the requirements of the public offer test contained in subsection 128F(3) or (4). In the absence of the exemption, IWT would be payable on the interest paid to foreign debenture holders;

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a new parallel provision, section 128FA, is being inserted by the New International Tax Arrangements Bill 2003 to provide an exemption in respect of the interest on debentures issued by certain unit trusts, similar to that provided for the interest on debentures issued by companies (by section 128F);

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section 128GB provides an exemption from IWT on interest paid by offshore banking units on offshore borrowings including interest consisting of gold paid in respect of offshore borrowings.

What is the public offer test?

3.10 As mentioned in the preceding paragraph, a public offer test must be satisfied for interest to be exempt from IWT under section 128F or the proposed section 128FA. The issue of debentures will need to satisfy one of five tests. These tests are satisfied if a debenture is offered:

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to at least 10 persons who were each carrying on the business of providing finance, or investing or dealing in securities, as participants in financial markets;

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to at least 100 investors who have acquired debentures in the past or could reasonably be likely to be interested in acquiring debentures;

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as a result of being accepted for listing on a stock exchange, where the company or trustee of the unit trust had previously entered into an agreement with a dealer, manager or underwriter, requiring the company or trustee to seek such listing;

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as a result of negotiations being initiated publicly in electronic form, or in another form, that was used by financial markets for dealing in debentures or debt interest; or

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to a dealer, manager or underwriter for the purpose of placement of the debenture if the dealer, manager or underwriter satisfies one of the previous tests.

3.11 An issue of debentures will always fail the public offer test, with consequential loss of eligibility for the exemption, if at the time of issue the company or trustee was aware or suspected that the debentures would be acquired by the issuing company's or unit trust's associates, other than associates acting in the capacity of a dealer, manager or underwriter. The exemption is also denied if the issuing company or trustee is aware or suspects that the interest in respect of the debentures is being paid to an associate of the company or trust.

Update references to debenture and offshore borrowing

3.12 Part 1 of Schedule 3 introduces the term 'debt interest' into section 128F and the proposed section 128FA so that non-equity shares such as redeemable preference shares and other debt interests may qualify for an IWT exemption (provided certain conditions are met). The use of 'debt interest' reflects the use of 'debt interest' in the Income Tax Assessment Act 1997 (ITAA 1997) and the changes to the meaning of interest following the debt/equity amendments of 2001. [Schedule 3, items 7, 8, 10, 11, 12, 14, 15, 19, 20, 21, 23, section 128F; items 25 to 28, 30 and 31, proposed section 128FA]

3.13 While not all payments on debt interests are classified as interest, the exemptions still only apply to amounts that are interest. Even if made in respect of a debt interest, a payment that is not interest will not qualify for the exemption. In any case, it is unlikely that such payments are subject to withholding tax in the first instance.

3.14 As some debentures pay interest but may not fall within the proposed definition of 'debt interest', the term 'debenture' has been retained. No change to the treatment of interest paid on a debenture is intended by the amendments.

3.15 In order to give effect to the changes to section 128F, the term 'debt interest' has been included in the provisions relating to the deeming of a number of debentures to be a single loan and those relating to global bonds. The definition of security has also been amended to include debt interests. [Schedule 3, item 3, paragraph 128A(5)(a); item 4, subsection 128AE(1); item 24, subsection 128F(10)]

3.16 The modified definition of 'qualifying security' has been amended to include debt interest. This will ensure that where transfers of debentures and debt interests that are qualifying securities give rise to interest, the interest may be exempt from IWT. This amendment is not intended to bring within the IWT provisions debt interests that do not give rise to the payment of interest. [Schedule 3, item 2, subsection 128A(1B)]

3.17 The inclusion of debt interest in the definition of security will update the concept of 'offshore borrowing' in relation to offshore banking units because the definition of 'borrow' in section 128AE includes the raising of finance through the issue of a security. This will make it clear that interest paid on any type of debt interest, including non-equity shares, may qualify for the IWT exemption under section 128GB. It will also clarify the scope of section 128NB.

3.18 The provisions relating to the public offer test, which provide the basis for IWT exemptions for debentures issued by companies and eligible unit trusts, have been amended to include debt interests. The provisions relating to the issue of debentures that always fail the public offer test have been broadened to include interests in debentures or debt interests. [Schedule 3, item 13, subsection 128F(3); item 16, paragraph 128F(5)(a); item 17, subparagraphs 128F(5)(b)(i) and (ii); item 18, paragraph 128F(5)(c)]

3.19 Subsection 128F(8) sets out the conditions that must be satisfied before interest paid on debentures issued through a foreign subsidiary can qualify for the IWT exemption. It provides that, in order to qualify for exemption, the parent company must own all of the issued shares in the subsidiary. An equivalent rule applies to the trustee of an eligible unit trust in subsection 128FA(5). As non-equity shares, such as redeemable preference shares, are treated as debt interests in the IWT exemption provisions, an amendment to this provision is required to ensure that the subsidiary can issue eligible preference shares without losing the IWT exemption. [Schedule 3, item 22, paragraph 128F(8)(a); item 29, proposed paragraph 128FA(5)(a)]

3.20 Where possible the concept of 'debenture' has been broadened to include 'debt interest' in section 128F and the proposed section 128FA. However, some provisions have required modification to this approach to apply 'debt interest' correctly. [Schedule 3, item 6, subsection 128F(1); item 9, subsection 128F(1A)]

Expand the definition of interest to include payments made on capital instruments which are debt interests under regulations

3.21 For prudential purposes, Australian banks have to differentiate their capital between Tier 1 and Tier 2 capital. Upper Tier 2 capital is of a lower quality than Tier 1 capital and is essentially permanent in nature. It includes asset revaluation reserves, general provisions for doubtful debts and certain hybrid capital instruments approved by the Australian Prudential Regulation Authority such as cumulative redeemable shares, mandatory convertible notes and perpetual subordinated debt.

3.22 The Government proposes that Upper Tier 2 capital instruments issued by banks will be treated as debt for taxation purposes. Regulations are to be made to do this. This would mean that returns on this type of instrument paid on or after 1 July 2001 would qualify as tax deductions for the banks.

3.23 The payments on certain types of Upper Tier 2 instruments do not fall within the meaning of interest for withholding tax purposes, nor are they dividends. Therefore, withholding tax would not be payable when the payments were made from Australia to non-residents. To ensure that the payments are subject to IWT they have been included within the meaning of interest for IWT purposes. In the appropriate circumstances, those payments would also qualify for an IWT exemption (e.g. under section 128F) because they are made on debt interests. [Schedule 3, item 45, subsection 128A(1AB)]

The transfer of debentures from Australian subsidiaries of foreign banks to their Australian branches

3.24 Amendments to the IWT provisions in 2001 allowed the branches of foreign banks to issue debentures under section 128F which would be free of IWT. The amendments were intended to remove the costs of operating special Australian subsidiaries that were used to gain access to the exemption, and to avoid double taxation under the thin capitalisation rules when funds raised under section 128F are on-lent by a subsidiary to a branch.

3.25 However, the legislation was not amended to allow debentures that were issued by Australian subsidiaries of foreign banks after 18 June 1993 to be transferred to a branch without forgoing any IWT exemption. Consequently, these debentures were effectively locked into the subsidiary. The amendments in this bill allow IWT-free debentures to move from a subsidiary of the foreign bank to a branch without losing the exemption.

3.26 These amendments are made to the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 which is legislation that fosters the Government's policy of encouraging foreign bank branches in Australia by facilitating the transfer of assets and liabilities from Australian subsidiaries of foreign banks to their Australian branches. The Act achieves this by ignoring the tax effects of the transfers, including preserving the exemption from IWT for borrowings that were exempt from IWT under section 128F prior to their transfer.

3.27 The relevant IWT provisions are contained in section 23 of the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 which operates to modify the operation of section 128F. By it, interest paid by a foreign bank, rather than by its Australian subsidiary, on a liability transferred from the subsidiary will qualify for exemption from IWT when the other requirements of the section continue to be met.

3.28 Presently, section 23 is limited to debentures issued on or before 18 June 1993. This bill extends the IWT exemption to debentures issued after this date by amending paragraphs 2(ca), (cb), (cc) and (cd) of section 23 of the Financial Corporations (Transfer of Assets and Liabilities) Act 1993, to remove the restriction to debentures issued on or before 18 June 1993 and to interest paid after that date. Consistent with the first set of amendments, a reference to debt interests as well as debentures is also included. [Schedule 3, item 46, paragraph 23(2)(ca) of the Financial Corporations (Transfer of Assets and Liabilities) Act 1993]

Application and transitional provisions

3.29 The amendments made by this Schedule (except Part 3) apply to:

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interest paid on debentures or debt interests issued on or after Royal Assent; and

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payments made on the relevant capital instruments issued on or after Royal Assent.

3.30 The amendment made by Part 3 of the Schedule applies to debentures or debt interests issued after 18 June 1993 which are transferred on or after Royal Assent. [Schedule 3, item 47]

Consequential amendments

Arising from amendments to section 128F and proposed section 128FA

3.31 As the amendments to section 128F and the proposed section 128FA allow for the returns on certain redeemable preference shares to be exempt from IWT, it is necessary to amend the provisions relating to offshore banking units to ensure that their subsidiaries which issue redeemable preference shares may apply for offshore banking unit status. [Schedule 3, item 5, paragraph 128AE(2)(ba)]

3.32 The definition of 'security' in the provisions relating to offshore banking units has been amended to ensure consistency with that contained in the IWT provisions. [Schedule 3, item 1, section 121C]

3.33 Four sections of Division 820 in the ITAA 1997 (dealing with thin capitalisation) need amending to accommodate the introduction of the concept of debt interest into the IWT provisions. [Schedule 3, items 32 to 35, subsection 820-570(1) of the ITAA 1997; items 36 to 39, subsections 820-591(1) and (2) of the ITAA 1997; item 40, section 820-595 of the ITAA 1997; items 41 to 44, subsections 820-617(1) and (2) of the ITAA 1997]